Do not be detoured by bankers and their friends; our future financial salvation lies in the direction of Basel

Avinash Persaud23 September 2011

The financial crisis revealed substantive problems that need to be solved, especially in the banking sector. This column argues that Basel III, the new accord on international banking, is an overdue step in the right direction. It should be defended against attempts by bankers and their friends to cut it down, dilute it, and postpone it.

For the past decade I have been a trenchant critic of the international banking rules developed in Basel. Nine years ago, I wrote an editorial in The Financial Times1 highlighting the perverse irony of bankers capturing their regulators and yet fashioning international banking regulation in a way that would lead them to systemic collapse.

Basel III is worth defending

Once one becomes a critic it is always easier to remain one (press and conference organisers like it that way). But while the new accord on international banking, popularly known as Basel III, is far from perfect, it is on the right track and requires defending against attempts by bankers and their friends to cut it down, dilute it, and postpone it.

Bankers would like us to think that weak bank lending relates to tight and/or uncertain regulation. It is a seductive argument for politicians in Europe and the US as growth dries up and elections loom. But lending is weak because many borrowers are repairing their balance sheets and repaying loans. Many others are no longer creditworthy.

Basel III reforms represent a reorientation of regulation in the right direction; it reflects many lessons learned and some errors checked. The earlier the new rules are adopted, the earlier banking can shift to a more sustainable path, but once more banks are putting themselves at risk by trying to frustrate the process.

Financial crises are so complex with so many apparent causes that in their aftermath there is no shortage of clever solutions in search of a problem. Reforms are best measured by whether the problem they solve or address, if solved earlier, would have limited the crisis or, merely deflected it on to something else with little overall difference. The financial crisis revealed five substantive problems that need to be solved.

First, we were once more reminded that booms are fuelled by an underestimation of risks.

From the perspective of the ‘after-party’, banks lent too much, too rapidly, and with too much leverage. This behaviour was self-feeding as lending pumped up asset prices justifying further leverage. It was accelerated by the market-sensitive risk management approach and fair value accounting promoted by Basel II, in the name of Nobel-prize-winning sophistication and market discipline (see Persaud 2000).

Second, banking regulation cannot fight against the excesses of the credit cycle alone.

Monetary and fiscal policy must play a role. While the shortcomings of monetary policy in addressing a boom in one or two sectors are well recognised, the importance of fiscal policy is too often forgotten. Overly loose fiscal policy in the US after the dotcom-bubble burst was a bigger contributory factor to the excessive consumption and overvalued dollar that fed the boom than monetary policy.

Regulatory policy must, at the very least, not amplify the credit cycle and this is what Basel II did. The Basel Committee responded with limits on leverage (the ratio of lending to equity) and countercyclical capital reserves designed to curb the enthusiasm for lending at the top of the economic cycle. I would argue for an even lower leverage ratio - say twenty times capital - and larger countercyclical provisions; but given Basel II had put all its faith in procyclical, market-sensitive risk-weightings, this is a good start, in the right direction.

Third, given the natural tendency of banks to underestimate risks in a boom, Basel II was too kind to large banks, allowing them to use their own internal risk systems to set lower regulatory capital, encouraging these systemically important institutions to grow in line with their own hubris.

Basel III responded with higher capital charges for systemically important institutions, better internalising the risks their size poses to the financial system. It is doubtful that these additional charges are big enough to change lending behaviour, but given Basel II had previously been shackled from doing this by the self-imposed imperative of ‘level playing fields’, this also is a good step in the right direction. Recent research on the effect of higher capital adequacy ratios on lending suggest that bankers do protest too much (see Miles et al 2011).

Fourth, the derivative markets have far outgrown their cash markets.

This is less worrisome than many feel in their bones. It is nonetheless a genuine problem in the fog of crisis. Whenever the large derivative markets encounter a crisis, problems arise from the fact that there is uncertainty as to where vulnerable positions are and how they are being unwound and netted off.

The Basel Committee responded, in an admirably measured way, by supporting new rules on mandatory trade reporting and incentivising the central clearing of all trades. Putting all exposures on balance sheet would also help, but to be fair that was already part of Basel II – implementation was just too slow. I believe that a small transactions tax may also help in limiting the production of systemically risky but socially questionable financial turnover.

Fifth, this was a crisis of funding liquidity.

Basel II largely ignored liquidity and so the banks were incentivised to borrow cheaply from the markets rather than expensively from customers. This business model boosted profits during the calm time, but market liquidity is ephemeral and when things turn tricky it vanishes. This would have led to an economy-wide insolvency if banks were then forced sell all of their illiquid securities at the same time – which is why the central banks had no alternative but to step in. Those who believe that authorities should have stood still and let the banks fail have little history on their side to support such a courageous position.

Basel III has responded with a fundamental reform that requires banks to be better insulated from periods of financial market illiquidity and requiring a better matching of maturities of lending and borrowing. This latter proposal has elicited the greatest protests from banks and implementation has been kicked down the road till 2018. Bankers argue that borrowing short and lending long is what banks do. The correct response should be: “Exactly!” Most financial crises are rooted in liquidity problems in the banking system.

The nature of this crisis has meant that ‘credit risk transfer’ is seen as the villain of the peace, but we are in danger of throwing out the baby with the bath water. As Professor Charles Goodhart has bravely remarked, one of the underlying problems of the crisis was that there was not enough risk transfer, merely the transfer of illiquid assets off the balance sheet of the same institution.

The financial system would be safer if illiquid assets flowed out of the banking system towards insurance and pension funds and liquid assets flowed the other way. The principal-agent problem, where banks that originate debt in order to sell it on are not incentivised to care about the quality of the debt, is real enough, though in danger of being exaggerated, and can be managed by shifting bank remuneration for this activity from up-front origination fees to annual fees relating to the performance of the debt. One of the obstacles to a systemically safer allocation of risks is that the new regulation of holders of long-term liquidity like insurance and pension funds (Solvency II) discourages them from owning illiquid assets through increasing emphasis on market-sensitive value accounting and short-term solvency ratios. The only thing worse than Basel II was Solvency II.

To reduce systemic risks, individual risks need to be able to move to where they can be better absorbed. The name of the game is optimal risk allocation across the financial system. It is not about getting in the way of risk transfers by putting up barriers and lobotomising the financial system.

Concluding remarks

The real problem with Basel III is that the opportunity – presented by the crisis and the creation of the Financial Stability Board – for joined-up regulation in the name of better managing risk at the system-wide level was not grasped.

Grandly sounding systemic risk committees made up of the same people who missed the crisis the first time around isn’t an adequate response. But let us at least ensure that those issues that were grasped by Basel III are not abandoned through pressure from banks arguing that the new regulations are the root of weak lending.